Emerging market debt had a tumultuous year in 2011. Following a strong start, the second half of the year proved a challenging environment for the asset class.
Over the first six months of 2011 both hard and local currency emerging market bonds were firmly in positive territory, as measured by JP Morgan’s (JPM’s) sovereign indices.
This is in contrast to emerging market equities which started off the year poorly but ended up about flat at the half-way point, according to MSCI.
By the summer, however, market sentiment had soured and risk assets globally suffered, declining significantly as investors worried about the politics of the European periphery and the attitude of ratings agencies towards the governments of the West.
September was a particularly difficult month, with local currency indices off about 10%, while hard currency benchmarks fared a little better, off about 5%, thanks to their correlation with American government bonds. This represents the worst one-month return for the asset class since October 2008 and has prompted some investors in the market to call time on emerging market debt. (Trends continues below)
While tail risks remain, it is possible that after returns of more than 50% between January 2009 and June 2011, emerging market debt has undergone a correction.
Following the rout in September 2011, while volatility was elevated, emerging debt markets rebounded by about 0.5% in local currency and 4.7% in hard currency by the end of the year, as measured by JPM indices.
Parallels with 2008 are not wholly justified. According to Gavekal, emerging market GDP growth is expected to average over 6% in 2012. However, emerging market debt mutual funds saw £3 billion of outflows from the 2011 peak of £27 billion reached in early September, according to JPM data published at the end of November.
This is in contrast to the significant inflows that the asset class has enjoyed since 2009. If investors are driven to liquidate significant positions it will continue to place downward pressure on prices.
We have already seen this in parts of the credit market, such as high yield during the summer of 2011, as liquidity dried up and investors headed for the exit. The risk in emerging market debt would seem all the greater given concentrated levels of foreign ownership in some countries.
However, this pressure seems to have eased following the initial wave of selling and it is likely that this risk is overdone. In contrast to credit asset classes such as high yield, institutional investors are largely under allocated to emerging market debt and structurally need to buy more. It is also important to recognise that, despite the seemingly high investor concentration, the composition of the investor base is much more diversified compared with 2008.
At the same time, emerging market sovereign fundamentals remain robust. Emerging market governments boast £4.1 trillion of foreign currency reserves, an improvement of £1.4 trillion since October 2008, debt levels that in many instances are materially lower than those in the developed world and generally more attractive fiscal positions.
There are also strong signs that inflation has moderated.
Asia has the greatest share of emerging market foreign currency reserves at £3.1 trillion, according to JPM with deficits in the region expected to average just 0.5% of GDP this year (excluding China & India). Furthermore, inflation in the region is expected to moderate to 3.2% from 4% (excluding China & India). This puts the region’s central banks in a strong position to stimulate domestic economies to offset declining demand for goods and services elsewhere in the world.
”It is possible that emerging markets have the firepower to respond to the downturn in the global economy”
Some emerging market debt fund managers benefited from this opportunity in the third quarter of 2011. Food is a larger part of emerging market inflation baskets and so exerts a greater effect on inflation indices compared with developed markets. The large run-up in food prices seen during 2010 was therefore an important driver of the increase in inflation.
The first half of the 2011 was more about emerging currencies than bonds. However, using the Korean won as an example, gains initially made in currency in the first half reversed in the second half of 2011.
At the same time, falls in the inflation rate together with interest rate cuts in some emerging markets countries led to better performance in bonds and fund managers with greater sensitivity to interest rates benefitted from this.
It is possible that emerging markets generally have the firepower to respond to the downturn in the global economy. We have already seen evidence of this with several emerging market rate cuts since the summer of 2011.
So what are the prospects for emerging market debt? It is likely that the long-term investment case for the asset class is intact. The continued economic and financial strength of emerging economies relative to their developed counterparts, the increasing share of global GDP they are set to gain, together with attractively valued currencies and rising average credit quality continue to inspire confidence in the asset class.
Anthony Gillhamis a portfolio manager at Skandia Investment Group.